Tuesday 8 December 2009

IFA Calculator Demonstrates the Diversified Portfolio Superiority

Those who want to check the advantage of a diversified international portfolio may want to try out the superb IFA Index calculator over at IFA.com. Though addressed to US investors using US dollar data, the principles and the nature of the results for Canadians would be largely the same.

The folks at IFA have incorporated several unique and valuable features:
  • inflation (US data) button to see real returns
  • dividends included to get total returns not just the index value increase
  • long history back to 1928 extending right up to October 2009
  • time period selectable of any duration - find the best or worst case scenario that has happened in the past
  • regular (annual) deposits in dollars or percentage can be added, or
  • regular (annual) withdrawals in dollars or percentage too, making this especially useful for a retiree (if you use this option be sure to turn off the "adjust for inflation" in the returns section at step 4; otherwise you would be double counting inflation)
  • realistic portfolios with a wide range of asset classes and weights for any from the ultra-cautious 85% fixed income to the ultra-aggressive totally equity portfolio allocation or,
  • individual asset classes (21 altogether) like REITs, emerging markets, US and international small cap and value, with reconstructed historical data (these are synthetic and thus not fully realistic but IFA appears to have tried very hard to line them up properly)
  • annual rebalancing of every portfolio
  • tax calculation option for funds in a taxable account (US tax rates)
  • portfolio returns adjusted for the maximum annual fees of 0.9% that IFA charges its clients
It all adds up to being able to model the past in a very realistic manner unlike so many other calculators I have come across. This calculator is not world class, it is the best anywhere on the Net.

Portfolio Advantages:
One of the comparator asset classes is the S&P500 index (in step 1, scroll down the Indexfolio list to the bottom to get it). I used the worst ever 20 year rolling period of 1962 to 1981 (yup, it even beats 1929 to 1948 if you look at the handy 20-year chart from AllFinancialMatters blog on S&P500 Rolling Period Total Real Returns; call this the "financial death by inflation" period of modern history). The comparison of a conservative middle of the road portfolio - IFA's Index 45 - to the S&P500 shows the following:

1) Simple buy at the beginning and hold throughout
  • S&P500 - total return 15.56% or 0.73% per year compounded with standard deviation 14.72%
  • 45 portfolio - total return 68.34%, or 2.64% p.a. and 9.12% std dev
  • the portfolio got much higher return at much lower risk
2) Buy $1000 at start and invest $10 real per month ($120 annually) (i.e. rising with inflation)
  • S&P500 - total return 261.71% / 6.64% annualized and 14.57% std dev
  • 45 portfolio - total return 426.93% / 8.66% annualized and 8.88% std dev
  • the advantage of the portfolio is even greater than buy and hold
3) Retiree starts with $120,000 and withdraws $400 real per month (i.e. $4,800 per year = 4% of initial capital, which is the rule of thumb sustainable withdrawal rate)
  • S&P500 - same % return and std dev as for additions (it's just the mirror image); whew! the rule works as after the worst ever period, the S&P500 only investor has weathered the storm and the portfolio survived with a balance of $144,000 in December 1981and better times ahead, though he/she doesn't know it ... by 1991 the balance is up to $299,000
  • 45 portfolio - returns are higher here too and the end balance is $263,000; just for fun, I played with numbers to see how much could be taken out to end up with the same as the S&P500 - and the figure is around $6,300 per year, a whopping 37.5% more money for the retiree to spend! That is a 5.25% withdrawal rate. The money would have run out in April 1997, so a person could have spent 35 happy years in retirement.
IFA does tout that its funds and portfolios outperform on both risk and return what a DIY investor might be able to achieve using index ETFs or mutual funds like those of Vanguard so the actual numbers and potential withdrawal rates might not apply to an individual DIY investor. Nevertheless, the calculator provides a powerful argument for the value of holding a diversified portfolio.

Many thanks to IFA advisor Brad Von Grote who pointed out the calculator and spent a considerable time on the phone chatting with me. In case anyone wonders, IFA hasn't paid me to praise their calculator and I am not a client of theirs though I think a person could do far worse than sign up with them. I only wish they would create something similar for their Canadian audience.

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